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How the stock market rally is feeding on itself

The emergence of brash retail traders who think stocks only go up has been one easy explanation for the surprisingly strong market recovery since March.
Some analysts, however, argue the rebound has more to do with the same technical factors that exacerbated the initial bear market — the rise of volatility-sensitive investors and the increasing influence of derivatives on financial markets.

“Positioning played a huge role in the extent of the sell-off, and has been a big part of the rally as well,” said Bankim Chadha, chief global strategist at Deutsche Bank.

Markets have long been characterised by “procyclical” forces that magnify peaks and troughs. Investors are naturally flightier at times of turmoil, and become more bullish as markets rise. But volatility is now embedded into virtually all risk management tools. When turbulence rises, traders are forced to ditch positions, and when it falls they get the green light to dive back in.

There has also been rapid growth in recent years in investment strategies that are even more closely tied to the level of volatility. These include trend-following hedge funds, risk parity funds that allocate to a wide array of assets weighted according to their volatility, and managed volatility products sold by insurance companies.

Low bond yields have also nurtured the growth of derivatives-based strategies, where investors look to secure extra streams of income by selling potential market gains through call options, or protect against calamities through put options. On the other side of these transactions are banks and other investors that want to generate returns by buying the upside or selling protection against falls.

“One of the lessons of the past decade is that long periods of low yields have a lot of side-effects, and this is one of the costliest,” said Luca Paolini, a strategist at Pictet Asset Management. “Financial engineering does nothing to help the economy long-term.”

hen markets are particularly choppy, rising volatility can force banks to hedge their exposure to these derivatives by selling their stocks in already falling markets. Many analysts say that the price swings in March were made more severe by volatility-sensitive funds ratcheting back their positions, and bank trading desks hedging their options exposures.

When volatility falls, however, the dynamics are reversed — which some say may be a factor in the strength and speed of the market recovery. The Vix index of equity-market volatility, sometimes called Wall Street’s “fear gauge”, has slumped from a high of over 80 in mid-March to about 32 this week, though it is still above its long-term average of about 20.

That reduction in turbulence has spurred trend-following hedge funds to cover short positions and buy stocks again, analysts note. Risk parity funds tend to move more slowly, but managed-volatility funds have added up to $20bn to their equity exposures in the past two weeks, after the longest stretch of daily increases in allocation since October 2019, according to Deutsche Bank.

A recent surge in options trading — driven in part by gung-ho day-traders — has also likely contributed to the rally. Goldman Sachs estimates that at about $5tn, the open interest of options is now about a fifth of the S&P 500’s overall market capitalisation, compared to an average of 14 per cent of the US benchmark index in 2013-2017.

Moreover, about 20 per cent of all S&P 500 options traded since the beginning of April have had a maturity of less than 24 hours, up from 3-5 per cent in 2011-16, according to Goldman Sachs.

This can have an impact on the actual equity market, akin to the tail wagging the dog. Options with a closer maturity are generally more sensitive to changes in prices. For example, when an investor buys a call option maturing the next day, the counterparty in the trade may be forced to buy the underlying stock to hedge its exposure as it rises closer to the strike price.

Not everyone is convinced that technical factors such as these have played a big role in the rapid revival since March. One volatility-focused hedge fund manager stressed that the effects of such factors tend to be greater when markets are tumbling.

However, Mr Chadha points out that stock market liquidity — a term used to describe how easily assets can be bought and sold — is still relatively low, so even modest increases in equity exposures can have an outsized impact on prices.

Given how many volatility-sensitive strategies still have small weightings in stocks, and are likely to ramp them up in coming weeks, he reckons the rally has further to run. “The risk is that the recovery is a lot stronger than people expect,” he said.



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